Trade wars: Australia could get badly hurt if giants collide

Over the past six weeks, both the Australian dollar and China’s renminbi have been depreciating significantly against the US dollar. It’s no coincidence.

The shifts in currency do, however, coincide with the escalation in the rhetoric, and actions, of the Trump administration on trade, with last week’s outburst from Donald Trump adding a fresh note of uncertainty and a new bout of volatility to the currency markets.

The deteriorating relationship between the US and China is of real economic significance and is proving to be a major influence over the value of the Australian dollar.Credit:Louie Douvis

On Friday, Trump said China and the European Union were manipulating their currencies and interest rates lower, and repeated a threat to slap tariffs on all $US505 billion ($680 billion) of Chinese imports into the US.

He paired that with another tweet saying that the US Federal Reserve board’s tightening of monetary policy and raising of US rates was hurting all his administration had done.

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In subsequent interviews, he said he wasn’t happy that the Fed had been raising rates and that the strength of the US dollar put the country at a disadvantage while China’s renminbi had been "dropping like a rock". (The White House later said he respected the Fed’s independence and wasn’t interfering with its policy decisions).

Nevertheless, Trump’s commentary on the Fed and the US dollar raised the prospect that he might open another front in the trade wars the US has initiated.

It’s true that the renminbi has been sliding in value against the US dollar to levels last seen a year ago. It has depreciated about 4 per cent against the US dollar in the past month. Over the same period, while now trading at around US74¢, or roughly the same levels at which it started the month, the Australian dollar has bounced between US73¢ and US75¢ while remaining relatively stable against the renminbi.

It is quite obvious that, while not directly exposed to the trade conflict that has developed between the US and China (and the US and much of the rest of the world), Australia has a very large and economically vital indirect exposure through our trade relationships with China, which accounts for about 30 per cent of our exports.

Thus, the deteriorating relationship between the US and China is of real economic significance and is proving to be a major influence over the value of the Australian dollar. It’s not the only influence – the dollar is still moved by domestic economic and financial data, which have been relatively positive – but it is of consequence.

If Trump were to go ahead and impose tariffs on all China’s exports to the US it would inevitably have a major adverse impact on China, which would equally inevitably retaliate. It can’t match the threatened tariffs – it imports only $US130 billion of goods from the US – but there are a range of non-tariff measures it could employ.

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Among them is a significant depreciation of its currency to make its exports more competitive and effectively offset the impact of the US tariffs. Trump believes that is already happening, even though China’s authorities have said they won’t embark on a currency war.

Trump had accused China of manipulating its currency during his election campaign. He was right – at the time China was "manipulating" the renminbi with policies designed to strengthen it, not weaken it. Apart from trying to avoid the very trade tensions that have now arisen, it was part of the authorities’ strategy of trying to shift their economy from one that was export-focused to one where domestic consumption drove a greater share of growth. They have been quite successful in doing that.

The US Treasury produced half-yearly reports monitoring the foreign exchange policies of America’s major trading partners. In its latest report, issued in April, it said China’s currency had "generally moved against the dollar in a direction that should, all else equal, help reduce China’s trade surplus with the United States’’ last year.

To the extent that there has been a depreciation of the renminbi against the dollar there are rational explanations that have nothing to do with China manipulating the currency or using it as a weapon (yet) in the trade conflict.

China’s economic growth rate slowed this year as authorities tried to crack down on excessive leverage and risk in the financial system. Recently the authorities have had to cut the reserve requirements for lenders to try to blunt the effects of higher borrowing costs for Chinese corporates.

Even without the trade dispute, the currency would be weakening because China’s economy has weakened and the perceived risks within the economy have risen. The trade war exacerbates those issues.

On the flip side, the US dollar has strengthened because the US economy is growing at a healthy clip. Even before Trump took office the economy was posting solid growth numbers but that growth has accelerated in response to the Trump tax cuts, the repatriation of cash held by US companies offshore and the degree to which the administration has removed regulation.

While Europe and Japan still have quantitative easing programs in place – buying bonds and mortgages to keep their interest rates at or near zero – the Fed has been raising rates and winding back its balance sheet, even as the US government borrowing requirement has been significantly increased by the need to finance the Trump tax cuts and big increases in spending.

In the circumstances, even without the trade conflict the US dollar would be strengthening against third-party currencies purely on its fundamentals.

The Australian dollar will be a good barometer of the intensity of the hostilities.

If Trump follows through with his threat to impose $US500 billion of tariffs on China (and imposes tariffs on European cars) it would only force the currency relativities further apart, as well as pushing up US inflation and forcing the Fed to tighten further and faster.

Australia is a largely innocent bystander in the trade wars but could be badly hurt if the giants do collide. The Australian dollar will be a good barometer of the intensity of the hostilities.

Stephen is one of Australia’s most respected business journalists. He was most recently co-founder and associate editor of the Business Spectator website and an associate editor and senior columnist at The Australian.